“There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds — cash plus sensible borrowing capacity — beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated. To this we add a caveat: Shareholders should have been supplied all the information they need for estimating that value. Otherwise, insiders could take advantage of their uninformed partners and buy out their interests at a fraction of the true worth.” One might have heard of this famous quote by Warren Buffett! This article aims to explain the concept of share repurchase and reasons for the same.

Stock buyback or share repurchase is the process where in a corporation repurchases its stock from the existing shareholders in exchange for cash. This process essentially reduces the number of outstanding shares in the market and therefore each shareholder gets a higher share of the future earnings. Hence most often shares repurchase programs push up the share price on account of increased EPS (Earnings Per Share). In order to get a fair idea of a share repurchase program, it is essential for the investors to understand facts and motives behind such a program. Some of the major facts often unknown shall be brought forth here.

There are two sides to a share repurchase program: The logic or motive of the management to go in for a share repurchase and the right price or Intrinsic Value of the share. The management of the company can go in for a share repurchase for various reasons and these reasons can be positive or negative.

Share repurchase: The Pros

Measure against a hostile takeover

Companies with extremely good future cash flow expectations will be a good target for a takeover if such information is not considered into the current stock price. In short the shares are said to be undervalued if you consider the bright prospects. Hence when the management wants to protect the company against a hostile takeover they can resort to share repurchase at the lowest price bands and reduce the free float of outstanding shares in the market. A takeover by another company after a round of share repurchase will be tougher as the acquirer will have to negotiate with higher price-seeking shareholders.

Another advantage for the management will be that getting a majority stake will be tougher for the acquirer considering the reduced number of available outstanding shares. In Mid-2007 buyout firms were going aggressive and leaving no opportunity to buyout efficient firms. As a reaction to this Expedia (EXPE) authorized a share repurchase in June of 2007 to protect itself against a buyout. A look at the outstanding shares figures of FY 2007 and FY 2012 reveals that the stock count has decreased by 183.82 million shares or a reduction of 56% in number of outstanding shares.

Share price does not reflect the intrinsic value of the company

When the shares are significantly undervalued in the market the management will resort to a share repurchase in order to support the price and increase the value per share. This will lead to an increase in the price to a level which more accurately reflects the intrinsic value per share.

Consider the case of Apple (AAPL). The companies operations continue to make record profits in terms of absolute profits, profit per customer and also profit per sqft of their retail space. Despite these facts the share price of the company has been on a decline for a major part of the last 6 months. Considering these facts it is not surprising to see the management announce a $60 billion stock buyback program. (See: Apple Q4 Earnings)

As of April the company had already repurchased shares worth close to $2 billion. Considering that the company continues to buyback shares evenly over the next few years the EPS and the share price of the company will continue to rise even if the company does not make any further growth in profits in the next 2 to 3 years. The only reason we can see behind these repurchases is that the shares are significantly undervalued and a repurchase will create long term benefits for the continuing shareholders and this will be reflected in the future price of the share.

Share repurchase as a corporate strategy

During times of slow growth or recession when the investors’ confidence in the stock markets is low, it is very likely that a company’s stock is undervalued due to the intense selling pressures in the market. During these times share repurchases can be an ideal strategy to generate long term value. Cash earnings from high growth periods, can be used to repurchase shares at the low price and therefore increase the future earning potential of each individual share. However the success of the strategy depends totally on the management’s accuracy in figuring out the right price or intrinsic value of the stock.

However as I said before there are also disadvantages to a share repurchase program and there can be instances of value destruction during a share repurchase. Value destruction can occur in any of the following ways and the investor must carefully look out for the following details which may not be very apparent.

Share repurchase: The Cons

Divert attention from a significant happening

There have been instances of managements going in for a share repurchase to project an image of confidence after some significant adverse happening. Here we would again like to bring to your notice the timing of Apple’s buyback program. This share repurchase program comes at a time when Apple’s ability to significantly innovate post the Steve-Jobs era is being questioned. This program can be seen as a signal of the management’s confidence in the company at a time when the market questions their abilities.

Short term Increase in EPS at cost of long term growth

In order to increase the short term EPS a company may be forfeiting opportunity to create greater wealth in the long term by reinvesting the money in the business. This generally happens when top-management performance is tied to earnings leading them to manipulate the EPS figures in order to earn a higher performance rating or bonus.

Another reason for share repurchase could be to achieve target EPS set for the company. A good example of this is IBM (IBM). The management has set an EPS target of $20 to be achieved by 2015. Therefore the management of the company has resorted to a very strong buyback program of IBM shares which in turn is leading to an increase in EPS, the growth rate of which is far higher at 60% per annum for last 10 years compared to the Net income growth at 36%. However a point to be noted is that IBM has supported the buyback program from its current cash flows and not from the past savings. Using the current cash flows to finance a share repurchase is sustainable in the long run when compared to using the past savings.

Information asymmetry

There can be an instance of information asymmetry with the insiders being better informed about the right price at which they must sell the stock. This can happen if some significant information is withheld from the general public. This can result in additional value for the shareholders in possession of special information at the expense of the other shareholders who choose to sell out.

Absolute count in shares outstanding

A number of companies very vocally come out with announcements regarding record setting share repurchase programs. However what they don’t state is the simultaneous dilution taking place by issue of ESOPS for employees and executive compensation. Taking once again the case of Apple, the company will reduce its outstanding shares count by close to 11% by the end of its $60 billion repurchase program in 2016.

Microsoft (MSFT) has spent close to $115 billion on share repurchases between 2002 and 2012. This was aimed at buying back nearly 4 billion shares. However a look at the share count states that the share count has in total reduced by 2.4 billion shares. Therefore the entire amount spent on the repurchase program is not entirely a benefit to the shareholders as many companies project it to be.

Therefore share repurchase by itself is not good or bad. It depends on the reasons behind the repurchase and the circumstances in which it is carried out. A look at the fundamentals of the company and an objective view is a must for an investor looking to assess the true value of a share before deciding whether or not to sell out in share repurchase program.

Apple Stock Articles & Video

Apple provided comments on the proposed Federal Automated Vehicles Policy paper on self-driving cars. The US administration is persuaded that the rise of self-driving cars is inevitable, and is mostly concerned with social impact and safety. Apple intends to leverage AI to ensure road safety, and seems to have initial road testing in mind.

Credit Suisse Analyst Kulbinder Garcha has restated Apple Inc. Stock at Outperform. The analyst claims that iPhone 7 builds will be at 87M units in December quarter, which will be an all-time high. Is Apple heading for a huge holiday quarter? Should investors buy AAPL stock?

Supply constraints and mixed signals from high-end Chinese consumers have weighed on Apple shares. I anticipate demand pull-through from Q1'17, suggesting that 10% y/y sales growth in China is attainable from Q2'17 onwards. This more optimistic scenario isn't priced into AAPL suggesting meaningful upside to earnings for the remainder of FY'17.

Apple Inc. has made preparations to start the holiday sales season on a high with a one-day sale on Black Friday. There are multiple reports of Apple releasing three iPhone models in 2018. With reports of up to 100M orders for OLED displays, Is Apple setting up for a massive FY 2018?

Neither Amigobulls, nor any members of its staff hold positions in any of the stocks discussed in this post. The author may not be a certified/registered investment advisor, and the opinions expressed should not be treated as investment advice. Buying and selling of securities carries the risk of monetary losses. Readers/Viewers are advised to carry out their own due diligence and consult their investment advisors before making any investment decisions. Neither Amigobulls, nor the author have any business relationship with any of the companies covered in this post.

show more

Comments on this article and AAPL stock

There is good reason why Mr. Buffet hates stock buy backs and stock splits.
If the company has too much cash, it should just pay dividends regularly. Isn't it unfair to all the AAPL investors in the past who helped the company to hoard so much cash? Now all the cash accumulated in back years will be used to reward future investors!
Anyway AAPL is no longer a great story after Jobs, who had made it into a cult!

• reply

Whatareyoutalkingabout - Jan 11, 2014 at 12:38 PM

What are you talking about BuffetisGr8? The only people who helped APPL hoard so much cash are ones who bought at public offering. If I buy appl shares that doesn't directly help apple at all.

Join Us On

Get Amigobulls On

Copyright2014 amigobulls.com

Historical, current end-of-day data, and company fundamental data provided by Zacks.
All information provided "as is" for informational purposes only, not intended for trading purposes or advice.
Neither Amigobulls nor any of the data providers is liable for any informational errors, incompleteness, or delays, or for any actions taken in reliance on information contained herein. By accessing the amigobulls.com, you agree not to redistribute the information found therein.
Please read our terms of use and privacy policy.